An organization's financial sustainability often depends largely upon funding from private and public donors. Nonprofit organizations (“NPOs”), for example, are especially reliant on donor contributions to maintain solvency. In fact, donors directly contribute hundreds of millions of dollars annually to NPOs. It is projected that NPOs will receive trillions of new donations over the next several decades.
Conventional charitable giving vehicles typically used by donors contributing to nonprofits include Foundations, Supporting Organizations, Donor-Advised Funds, Community Trusts, Pooled-Income Funds, Charitable-Gift Annuities, Charitable-Remainder Trusts, Charitable-Lead Trusts, and Proceeds of Life Insurance.
Foundations: Foundations are private philanthropic endowments that allow their participants to manage and oversee charitable activities. Donors receive income tax deductions as well as estate and gift tax deductions. Foundation types include community foundations, corporate foundations, family foundations, private independent foundations, and public foundations. Foundations can be established as either trusts or corporations.
Foundations offer their contributors the ability to accumulate tax-free investment income from the donated principal, and the freedom to select investment vehicles of their choosing. In addition, grants can be made to charitable organizations at the foundation board's discretion at any time and in any amount.
Foundations, however, carry considerable administrative burdens to establish and operate, including the preparation of state and federal tax returns, reports for filing with the state within which it operates, hosting annual foundation board meetings, and preparing the necessary minutes of meetings and board reports, providing notice, reports and other communication as required for board members, affiliated organizations, or related charities. Foundations usually hire staff to meet these reporting requirements, which adds considerable cost to the management of the entity. Initial contributions to establish a Foundation can be quite high, typically $500,000 or more. Foundations have a limit on the initial tax deduction that donors can take for contributed assets, restricted to 30% of Annual Gross Income (AGI) for cash contributions and 20% of AGI for gifts of securities. Foundations also require the payment of an annual excise tax, typically levied in an amount representing 2% of annual net investment income. Furthermore, Foundations are required to distribute a minimum of 5% of their net assets annually.
Supporting Organization (SO): An SO qualifies as a public charity rather than a private Foundation, and as such is eligible for better tax treatment of deductions than are recognized for Foundations. By definition of the Internal Revenue Service (“IRS”), SOs must operate exclusively for the benefit of, or carryout the purpose of, one or more 501 (c) (3) organizations. A Board of Directors appointed by the donor oversees the investment and use of contributed assets.
There are three types of SOs, and each must meet specific requirements prescribed by the IRS. One type requires the manager of the supported organization to sit on the SO's board. Another type requires the supported organization's board to appoint the managers of the SO to their board. The third type does not require commonality of management, but does require the SO to be “highly responsive” to the needs of the supported organization. This is currently the most popular type, in which donor and family appoint the board. The board must be independent, which excludes the substantial donor, their family members or employees, from exercising direct or indirect control (defined as board majority). However friends or advisors can be appointed to board positions.
This third type of SO must also meet a number of stringent tests in order to qualify as a public charity. For example, the SO has to distribute at least 85% of its income to one or more of the supported organizations annually. It must past an “attentiveness test.” The SO's grants must be substantial portion of the recipient's total revenue for the year in order to be considered “attentive.” It must also pass a “relationship test,” and be “operated in connection with” the charity. This requires the SO to be “responsive to the needs” of the charity and to maintain significant involvement with the supported organization because the supported organization depends on the SO for the type of support it provides.”
SOs can be an attractive alternative to private foundations in that they offer HFNDERSON greater tax deductibility (50% of AGI rather than 30%). They are often used as a means for the donor to hire family members at the SO to manage daily activities. They have no prohibition against self-dealing, no excise taxes, and no 5% minimum payout rules. The primary drawbacks of an SO include donor control and administration. Primary donors are disqualified from directly controlling the board, which is responsible for managing the investment of contributed assets. Although they can exercise some degree of influence by appointing trusted advisors to board positions, their influence over investment management is severely diluted. This is much less donor control than with an account under the present invention, which offers the donor sole discretion in determining and implementing investment strategy for funds that have been gifted. Additionally, there is significant administrative burden (and associated cost) with an SO. As a separate legal entity, an SO requires preparation and filing of legal documents to become established. Annual filings are also required with the IRS and some state authorities, though requirements are less onerous than with private foundations.
Donor-Advised Funds: Donor-advised funds are charitable-giving vehicles that pool donations from multiple donors, and are managed by professional advisors. Donors create their own separate accounts from which grants are made at the donors' discretion. Investments grow tax-free because gains remain in the fund and are added to the principal. Donors, however, realize a tax deduction in the year they donate the funds. Gifts to the fund immediately become the property of that particular fund. Donor-advised funds often include certain asset classes, but are generally limited to mutual funds rather than individual securities or alternative investments.
Donors generally can choose from a limited number of investment alternatives for managing their assets. When making a contribution, donors “advise” the fund how to distribute the monies, although each donor-advised fund limits the donors' choices of investment alternatives, as well as their right to reallocate assets at their discretion. Because donor-advised funds, to be exempt from the tax limitations applicable to private funds, are subject to the tax regulatory scrutiny comparable to public “community trusts,” they cannot be bound by the donors' wishes as to the ultimate charity to receive the donors' contributions, although funds typically follow the donors' wishes.
In addition, these funds must be able to use and control the contributed assets freely and effectively. These rules ensure that the donor-advised fund serves, for example, as a “component fund” for public charities, rather than merely a private foundation subject to more stringent tax requirements.
As stated above, Donor-advised funds typically offer only a very limited selection of investment alternatives for the donor, with available choices often limited to four choices or less, and rarely exceeding ten different options. The donor is also quite restricted in their ability to reallocate assets among investment alternatives, and is usually limited to just a few reallocations annually. Operating costs for donor-advised funds can also be comparatively high, as the industry average for operating costs of donor-advised funds is currently in the 1.5% per annum range.
Community Trusts: A donor may create a “designated fund” with a community trust organization that will make grants to a specified charitable organization or several organizations to fulfill a client's donative intent. Alternatively, a donor may create an “advised fund with a community trust organization, which is unrestricted; however, the client and/or the client's family may suggest how grants should be made. Although in theory the community trust organization is not obligated to follow such instructions, in practice they almost are always followed.
Advantages of community trust organizations include the absence of excise tax, relatively few administrative responsibilities, and minimum start-up costs. Disadvantages include lack of control, in that neither the donor nor his/her family will have direct control over the fund's grantmaking. Grants will have a less direct connection with a donor and his/her family than if they are made from the family or from an organization that bears the family name.
Pooled-Income Funds: Pooled-income funds are trusts that combine a donor's gift with other donors' gifts to benefit both the nonprofit and the individuals concerned. Generally, a nonprofit, or in some cases, a for-profit organization, establishes a pooled-income fund as a vehicle for donors who are interested in receiving income from monies they contribute. A donor (or designate) receives a proportionate share of the income earned from the fund each quarter, which varies based upon performance of the fund's investments. A tax deduction based on the actuarial value of the nonprofit's interest in the gift to the fund is realized when funds are donated. Upon the death of the surviving beneficiary, a proportionate share of the pooled income fund's principal is removed from the fund and distributed to the nonprofit for the purpose designated by the donor. Pooled-income funds often offer limited investment alternatives with differing risk parameters, typically including: (1) balanced funds offering investments that emphasize a mix of current income and long term growth, (2) growth funds emphasizing growth investments rather than income, and (3) current funds with investment objectives seeking a sustained high rate of income over the long term.
Investments grow tax-free, and each donor receives a share of the earned income. The nonprofit owns the funds during the investment period, but donors to pooled-income funds have limited investment choices available, and their ability to reallocate their investments is limited. The primary attraction of pooled-income funds is the income stream that they provide back to the donor. As such, they are less attractive to donors whose primary objective is to maximize the value of their contribution to the nonprofit organization. The income provided for the donor (or his designates) has a dilutive effect on the overall contribution, which runs counter to the primary motivation of certain types of donors. This fact, coupled with the inability of the donor to influence the management of gifted assets in any respect, limits the appeal of pooled-income funds for proactive donors seeking to make a significant impact on the nonprofit organization they are supporting.
Charitable-Gift Annuities: Charitable-gift annuities are agreements between a donor and a nonprofit in which a contribution is made in return for the nonprofit's promise to pay recipients a prearranged fixed income (i.e., a tax-free annuity) for life. Income payments can begin immediately or be deferred. The nonprofit either funds the annuity itself or, more commonly, uses the lump-sum donation to purchase an annuity from an insurance company. The difference between the cost of purchasing the annuity and the original donation is available for the nonprofit's needs.
The assets of the nonprofit organization typically guarantee annuity payments. The donor receives a tax deduction in the amount that the gift exceeds the total expected annuity payments. Once established, gift annuities are irrevocable. After the donation is made, the donor receives income from his contribution in the form of an annuity.
Charitable-Remainder Trusts: Charitable-remainder trusts are separately managed trusts established by a donor that provide income to the donor or another person for a specified term. Upon the death of the last surviving income beneficiary, the assets in the trust pass to the nonprofit to be used for the purpose designated by the donor. The tax deduction equals the value of the nonprofit's right to receive the trust's assets in the future, but the nonprofit does not guarantee these payments. Donors can contribute a variety of assets, including cash, stocks, bonds, and real estate.
Under a charitable-remainder trust, the donor may receive an income stream generated by the assets put into trust, but the donor must obtain a professional evaluation of the trust assets to determine its residual value for tax purposes. Typically, a minimum gift size may apply.
Charitable-Lead Trusts: Charitable-lead trusts are separately managed trusts that provide a fixed or variable income stream to the nonprofit during a specified number of years. At the end of the trust term, the assets pass back to the donor's heirs. This allows the donor to make a future transfer of assets to his heirs at substantially reduced gift and estate tax costs, while providing an income stream to the nonprofit for a term of years. If assets are left to beneficiaries other than original donors, this vehicle is called a “non-grantor-lead trust.” A trust in which the principal reverts back to the donor is called a “grantor-lead trust.” Distributions to the nonprofit can take two forms: (1) a unit trust values the trust assets annually and pays the nonprofit a fixed percentage of that amount; or (2) an annuity trust pays a fixed annual amount based on initial funding, regardless of the trust's fluctuating value. The nonprofit receives an income stream from assets put into trust, and the principal reverts to the donor (or a designate) at the conclusion of the charitable-lead trust. The nonprofit, however, does not receive the full value of the principal donation.
With Charitable-Gift Annuities, Charitable-Remainder Trusts and Charitable-Lead Trusts, the donor is looking for an annuity stream rather than management of the assets, and generally the donor has no or limited ability to manage the investments of such assets.
Proceeds of Life Insurance: Donors may arrange with a nonprofit for the purchase or transfer of a life insurance policy based on the donor's life. The nonprofit is named the owner and beneficiary of the policy. The donor makes regular payments to the nonprofit, which in turn makes the premium payments to keep the policy in force. Upon the donor's death, proceeds of the life insurance policy pass directly to the nonprofit. The donor receives tax deductions for the contributions made during their lifetime. If the donor stops paying for the premiums, the nonprofit can decide to continue paying the premiums. This vehicle allows a donor to create a gift, with principal generally growing on a fixed interest basis, to a nonprofit organization through tax-deductible insurance premiums.
Many donors have diminishing confidence in the abilities of NPOs and outside financial planners to effectively invest their gifted assets. The conventional donation arrangements described above, short of creating expensive and tax-restrictive private foundations, fail materially to provide donors with the ability materially to manage investments once a donation is made or to pursue post-donation investment alternatives without formidable administrative challenges. This ability to manage, build, and shape contributions, however, is often highly valued by donors and, in some cases, may serve as the principal motivation for making donations. Often, a donor desires to be a producer and influencer, rather than just a supporter or participant in their philanthropic activity. Such a donor typically wants to influence the investment allocations, not just expend accumulated wealth. Conventional donation arrangements do not enable participating donors materially to manage and allocate contributed funds in accordance with preferred investment strategies. Nonprofits have been slow to apply seminal research on donor motivations and characteristics, and the lethargy is likely to continue.
Methods, systems, and articles of manufacture consistent with certain embodiments of the present invention are directed to one or more of the issues set forth above.